The accounting cycle is a collective process of identifying, analyzing, and recording a company’s transactions. This standard 8-step process begins when a transaction occurs and ends with its inclusion in the financial statements and the closing of the books.
The key steps in the eight-step accounting cycle include recording journal entries, posting to the general ledger, calculating trial balances, making adjusting entries, and creating financial statements.
Key Takeaways
- The accounting cycle is designed to streamline the financial accounting of business activities, benefiting business owners.
- The process starts by recording transactions using journal entries and concludes with the closing of the books after financial statements are prepared.
- The accounting cycle typically covers a year or another designated accounting period.
- Modern accounting software largely automates the steps in the accounting cycle, reducing manual effort and errors.
How the Accounting Cycle Works
The accounting cycle is a structured set of principles that ensures the accuracy and compliance of financial statements. Today, most accounting software automates these steps, minimizing mistakes that can occur with manual processing.
Steps of the Accounting Cycle
There are eight crucial steps in the accounting cycle:
- Identify Transactions: The journey begins with identifying any transactions that warrant bookkeeping, such as sales, refunds, or vendor payments.
- Record Transactions in a Journal: All transactions are meticulously recorded using journal entries, based on invoices, sales recognition, or other economic events.
- Posting: These journal entries are then posted to individual accounts in the general ledger, which details all accounting activities by account.
- Unadjusted Trial Balance: An unadjusted trial balance is prepared to ensure total debits equal total credits in the financial records.
- Worksheet: A worksheet of debits and credits is created to identify necessitating adjusting entries in case of discrepancies.
- Adjusting Journal Entries: At the end of each period, adjusting entries are made, often due to corrections or accrued interest revenue.
- Financial Statements: After adjusting entries, an adjusted trial balance is prepared, followed by formal financial statements.
- Closing the Books: The cycle concludes by finalizing all temporary accounts and preparing a post-closing trial balance to verify that debits and credits match, making way for the new accounting period.
While most businesses utilize the accounting cycle, small businesses or entrepreneurs might use simpler methods.
Timing of the Accounting Cycle
An accounting cycle fits within an accounting period, which varies, although the annual period is the most common. Numerous transactions are recorded throughout, culminating in financial statement preparation at the fiscal year’s end. For public companies, these cycles align with mandatory reporting dates to regulatory bodies like the SEC.
Accounting Cycle vs. Budget Cycle
The accounting cycle focuses on correctly recording historical financial transactions, while the budget cycle is concerned with planning future financial operations. Though both play critical roles, the former serves external reporting needs and the latter enhances internal management strategies.
Why Is the Accounting Cycle Important?
The accounting cycle accurately captures and reports financial transactions, providing businesses with a clear insight into their financial health and ensuring compliance with federal regulations.
Benefits of the Accounting Cycle
The accounting cycle aids businesses by maintaining precise financial records, thoroughly analyzing financial events, and efficiently preparing necessary financial statements.
Who Is Responsible for Performing the Accounting Cycle?
Accountants typically oversee and execute the tasks in the accounting cycle. However, small business owners or one-person shops might handle these themselves or outsource to accounting firms.
The Bottom Line
The accounting cycle encapsulates an inclusive process that spans an accounting period to ensure consistent, accurate financial transaction reporting. Once an accounting period ends and the books are closed, the cycle reinitiates with the forthcoming financial transactions.
Related Terms: Financial Statements, Journal Entries, General Ledger, Trial Balance, Adjusting Entries, Closing Entries, Accounting Period.
References
- U.S. Securities and Exchange Commission. “Filings & Forms”.
